There are numerous concepts in finance that help a business grow and survive. Some concepts are based on how to invest, and some are based on when to invest and why. Time Value of Money (TVM) is one such concept. It states that the return a business gets is worth more at present than it will be in the future. It is one of the core principles in finance.
In this article, we will cover what the time value of money is, how to calculate it, its importance for a business, and its connection with the present value and future value of money.
What is the Time Value of Money?
It takes its own time for investments to grow and create a sizable corpus over a long period of time. However, at the same time, it makes investments vulnerable to long-term uncertainties such as inflation, interest rate risk, default risk, etc. As a result, the value of money is more in the present time than it would be in the future.
Let’s take a simple example. A company has just received a gain of Rs. 5,00,000 on one of its projects. It decides to put the money aside in a safe place instead of investing it. The question is, will Rs. 5,00,000 be worth the same after five years? The answer is no. In fact, the chances are thicker that it would reduce in value due to inflation. Instead, the money wouldn’t have lost its value if the company had invested the same amount in a bank FD, even at lower rates. We can also call it an opportunity cost.
The time value of money is related tightly to the rate of inflation as it directly impacts the investment. If the return earned is 7% and if the inflation is 9%, the investment is losing its principle (+7% – 9% = -2%) instead of gaining a return. Thus, it is crucial for a business to consider such factors for weighing investment options using TVM.
How to calculate the time value of money?
The time value of money can be determined by calculating the Future Value (FV) of money or Present Value (PV) of money.
The formula for calculating FV is:
FV = PV x [ 1 + (i / n) ] (n x t)
Where,
FV= Future Value
PV = Present Value
i = Interest rate
n = Number of interest compounding periods per year
t = Total number of years for the calculator purpose
To make it easy to understand, let’s understand it with an example.
Company X decides to invest Rs. 2,00,000 today at an interest of 6% for 3 years that compounds annually. What would be the future value of money for the sum invested?
FV = PV x [ 1 + (i / n) ] (n x t)
= 2,00,000 x (1 + (6% / 1) ^ (1 x 3)
= 2,38,203.20
The formula for calculating PV is:
PV = FV / [ 1 + (i / n) ] (n x t)
In the above example, let’s assume that the future value of the investment would be Rs. 5,00,000. If all the other conditions remain the same, how much the investment would be worth at present?
PV = 5,00,000 / (1 + (6% / 1) ^ (1 x 3)
= 419,809.64
It is to be noted that even a slight change in the interest rate or the interest compounding period can have a severe impact on the FV or PV of an investment.
For example, if in the above example of calculating FV, the compounding period is quarterly, n would be 12 instead of 3. The FV value, as a result, would be:
FV = 2,00,000 x (1 + (6% / 4) ^ (4 x 3)
= 402,439.29
What does it mean by the present value and the future value? Why do they matter for TVM?
- Future value: It is the value of current investments on a future date determined by the required rate of interest.
- Present Value: It states the current value of investments based on their future cash flow based on the interest rate.
FV and PV are two sides of the same coin. One cannot exist without the other. They both are crucial for determining the time value of money.
While the future value of money tells how much the investment made in the present time would be worth in the future, the present value indicates the exact amount needed to be saved today to earn a specific return in the future.
For a business, both of these values are important as it helps them to understand the viability of their investments and a reality check on the amount needed to be invested.
Why does the time value of money matter for a business?
- The time value of money calculation helps a business determine whether to take up a project or investment based on its worth.
- TVM also makes it easier for a business to compare the available alternatives and choose the best option available for investment.
- As TVM helps in knowing the worth of a project or investment, it helps in setting the required return rate and cost associated with the particular investment to streamline the overall business operations.
Conclusion
Businesses are required to make frequent investment decisions based on how much they are worth. The time value of money considers an investment or project’s present and future value, providing their accurate value. It makes it easier for businesses to compare multiple projects and investment opportunities to make the most suitable investment decisions.
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